Are BHEL, NTPC shares overvalued? Disconnect between perception and reality, says Kotak

In a strategy note, Kotak Institutional Equities said it struggles to understand the excitement around the electric utilities sector in India with the stocks having gone up sharply in the past six months. The underlying narrative, it said, seems to be a possible deficit in electricity generation capacity in India over the next few years. This, Kotak said, may be true but there are several anomalies with the narrative. 

Kotak said the electricity generation roadmap is still unclear but it would assume that the longer-term focus will be on renewables and any addition of new thermal capacity will be of a limited quantum.

"We are most intrigued by the market’s approach to valuing BHEL and NTPC. We use them as examples to demonstrate the exuberance among investors and the disconnect between perception (sentiment or price) and reality (fundamentals or value). Valuations may look reasonable on a cursory basis but a deeper look into the business models of the companies suggest that valuations may be on the higher side by a distance," Kotak said.

The brokerage said the economics of solar electricity generation are not very good currently with return on equity (RoE) lower than cost of equity (CoE). India has still not addressed the issue of distribution reforms and unremunerative electricity tariffs in several states, which raises questions about the viability (and value) of non-regulated electricity generation capacity. 

Kotak said  the ‘deficit’ narrative should not apply to Power Grid. 

In the 'curious' case of  Bharat Heavy Electricals Ltd  (BHEL), Kotak said the market is willing to give multiples to limited-period or limited opportunity earnings, a clear violation of any reasonable valuation framework. It said BHEL would need to deliver BTG (boiler, turbine, generator) equipment corresponding to 18-26 GW of new thermal generation capacity every year in perpetuity even using ‘low’ multiples in the reverse-valuation exercise. 

"This is patently absurd. BHEL’s market capitalisation can be justified only under a very bullish (and implausible) set of assumptions," it said. 

In the case of NTPC, Kotak said NTPC stock may trade at inexpensive valuations of about 13.8 times FY2025 earnings per share (EPS) and 1.7 times FY2025 book value, but it believes the stock is significantly overvalued. 

"As a starting point on NTPC’s valuations, we would note that the P/E multiple for NTPC’s extant coal-based portfolio should not exceed 9 times (assuming CoE of 11 per cent) assuming NTPC was to distribute all of its profits to shareholders in perpetuity. In fact, NTPC’s multiples should be below its ‘fair’ ex-growth P/E multiple of 9 times given question marks around the terminal value of its coal-heavy generation portfolio," Kotak said.

The domestic brokerage said NTPC’s current valuations imply the that its earnings will grow in perpetuity and shareholders will get sufficient dividends to justify the fair value today on an NPV basis. 
It finds the assumption questionable as NTPC has two options. The first is to use the current profits from coal-based generation capacity to put up sufficient renewable capacity over time, which means the company is unlikely to generate any FCF or distribute meaningful dividends for a long time. 

Th second option is to continue with its coal-based portfolio or even add more leading to a situation where these assets may/will have no value after 2-3 decades leading to zero or negative terminal value of the business. 

"Finally, we find it quite interesting that the narrative on NTPC stock also keeps changing depending on the market’s whims. The market was excited about its to-be-built renewable portfolio when the stock was at half the current market capitalisation and the market is excited now about its to-be-built coal-
based capacity. There is no visibility on the former and market speculation only about the latter," Kotak said.

The brokerage said its reverse-valuation exercise shows that NTPC’s current market capitalisation is already discounting 63 GW of new thermal capacity.